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Preview: Beware of Largest Tax Increase in History!

If Congress and the President do nothing by December 31, 2012, taxpayers will experience the largest tax increase in U.S. history in 2013.  This increase consists of expiring tax cuts enacted during the Bush II administration, expiring payroll tax cuts extended earlier this year and other tax increases passed as part of Obama Care that take effect in 2013.  These increases will exceed $4.3 trillion over 10 years.  The expiring provisions may not be extended as they were in 2010.  And, we are waiting for the Supreme Court to rule on the constitutionality of Obama Care, which may further impact the tax landscape.

Tax increases will not help individual taxpayers in a struggling economy.  Conversely, combined with the planned, mandatory reductions in discretionary spending, tax increases will put a dent into our ever-increasing deficit, possibly adding to our economic stability.

This month’s column focuses on the political landscape affecting the likelihood of tax increases occurring next year and some of the major changes we can expect if Congress takes no action before year-end.   Next month, I’ll focus on planning strategies in light of the expected increases.

Current stormy landscape.  Congress is deadlocked over the 2013 budget.  With the elections looming and the economy struggling, not many experts in Washington predict Congress will be able overcome the impasse on current budget issues, let alone tackle the extension of expiring tax cuts.  Last year’s deficit increase caused the total amount of debt outstanding  to equal 100% of the U.S. gross domestic product for the first time since World War II.  In 2011, Congress also agreed to cut discretionary spending by $2.1 trillion over 10 years, but could not agree on changes to mandatory spending (Social Security, Medicare and Medicaid) or the tax code.  Moreover, the debt limit probably will need to be increased again.  Against this backdrop, President Obama has pledged not to increase taxes on families earning less than $250,000 per year, the Republicans have pledged not to increase taxes on anyone and the Democrats have been unwilling to cut benefits for retirees.

The health care reform law enacted in 2010 will cost over $1 trillion over the next 10 years.  This is being paid for in large part by the new 3.8% “surtax” on net investment income (i.e., interest, dividends, rents, royalties and capital gains) for families with more than $250,000 in adjusted gross income ($200,000 for single taxpayers).  It is also being paid for by a new Medicare hospital insurance tax of 0.9% on earned income (i.e., salaries and bonuses) over $200,000 for single taxpayers and $250,000 for married couples.  These tax increases take effect on January 1, 2013.  Yet, the survival of health care reform (and possibly these and other tax increases hidden in health care reform) lies in the Supreme Court’s hands, with its fate expected to be determined by the end of June.

To top that, the 2012 elections are just around the corner.  Voters are deeply concerned about the economy.  Some predict Republican majorities in the Senate and House, with President Obama winning the election.  If this occurs but the Republicans do not achieve a veto-proof or filibuster-proof majority, we may see more of the same partisan politics that have plagued our country for the past several years.  All of this, to quote Jacob Lew, White House Chief of Staff, creates a “perfect storm for December 2012.”

If Congress Does Nothing…  On January 1st, the top tax rate on ordinary income will rise from 35% to 43.4%, including the net investment income surtax mentioned above.  Dividends, which are currently taxed at 15%, will be taxed at the highest rate (a 300% increase).  The estate tax exemption drops from $5.12 million per person to $1 million, and estate tax and generation skipping tax rates rise from 35% to 55% (a 57% increase).  The alternative minimum tax exemptions drop from their current levels to 2001 levels, which will subject many taxpayers to the AMT (others will escape AMT because their regular taxes will rise so sharply).  Rapid write-offs for business investments will disappear, payrolls taxes will rise above prior levels (due to the restoration of the full payroll tax and the additional HI tax imposed on higher wage earners), and various other incentives enacted to boost the economy will evaporate.  The big, unanswered question is whether these dramatic tax increases will have a chilling effect on our tepid economic recovery.

Outlook. Congress may not do anything to remedy this situation before the elections.  And, given the acrimonious tone of the debate leading up to the elections, it also appears questionable that Congress will reconvene after the elections in a “lame duck” session to deal with the perfect storm of budget and tax issues looming ahead.  Based upon this outlook, I will turn next month to ideas on how to plan for potential tax increases and the loss of expiring tax benefits.

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